Definition
Amortization can be broadly understood in different contexts:
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Amortization of Fixed Assets: The process of treating as an expense the cost of a fixed asset over its useful life. Commonly applied to leases, this method divides the acquisition cost by the number of years of the lease term, treating the result as an annual charge against profit. This allocation does not necessarily reflect the actual market value of the lease at any given time but is a fair way of distributing the original cost over periods.
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Amortization of Goodwill: Goodwill may also be amortized according to accounting standards, such as the Financial Reporting Standard applicable in the UK and Republic of Ireland, which mandates that goodwill should be written off to the profit and loss account in regular installments over its economic life.
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Amortization of Debt: The repayment of a loan by the borrower through a series of payments over time. Each installment typically covers both the interest and a portion of the principal amount.
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Spread of Front-End Fees: The distribution of the upfront fee charged when taking out a loan over the life of the loan for accounting purposes.
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Depreciation (USA Context): In the United States, amortization is sometimes used interchangeably with depreciation when referring to the systematic expensing of an intangible asset’s cost over its useful life.
Examples
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Lease Amortization: A company acquires a lease for $120,000 for ten years. The annual amortization expense would be $120,000 / 10 = $12,000.
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Goodwill Amortization: A business purchases another company and records $500,000 as goodwill. If the goodwill is set to be amortized over 10 years, the annual amortization charge would be $50,000.
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Loan Amortization: A borrower takes out a $100,000 loan at a 5% annual interest rate, payable monthly over 30 years. Each monthly payment includes both interest and a portion of the principal amount.
Frequently Asked Questions (FAQs)
Q: What types of assets are subject to amortization? A: Typically intangible assets such as goodwill, patents, and leases are subject to amortization.
Q: How is amortization different from depreciation? A: While depreciation often applies to tangible assets (like machinery and buildings), amortization applies to intangible assets and loan repayment.
Q: Can goodwill be amortized indefinitely? A: No, goodwill can only be amortized over its estimated useful economic life.
Q: How does loan amortization affect interest payments over time? A: In a loan amortization schedule, early payments primarily cover interest expenses; over time, more of each payment goes towards the principal repayment.
Q: Are there tax implications for amortization? A: Yes, amortization expenses can often be deducted from taxable income, reducing the total tax liability.
Related Terms
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Depreciation: The systematic allocation of the cost of a tangible asset over its useful life.
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Goodwill: An intangible asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.
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Principal: The original sum of money borrowed or invested, excluding any interest or dividends.
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Interest: The cost of borrowing money, typically expressed as an annual percentage of the principal.
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Intangible Assets: Non-physical assets such as patents, trademarks, and goodwill.
Online References
- Investopedia: Amortization
- International Financial Reporting Standards (IFRS) on Amortization
- IRS Topic No. 704 Depreciation
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield.
- Financial Accounting: A Business Process Approach by Jane L. Reimers.
- Principles of Accounting by Belverd E. Needles, Marian Powers, and Susan V. Crosson.
Accounting Basics: “Amortization” Fundamentals Quiz
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